George Soros’ Reflexivity Theory and the I Ching
There are many mystics in the investment world, but there are three that are the most easily recognized: Mr. Soros, Mr. Buffett and Sir John Templeton. They have all written works that almost touch on the spirituality of investing. Mr. Templeton has a beautiful piece of work on spirituality and has always been a strong moral force in the world. Mr. Buffet has crystallized for all time the almost mystical wisdom of investing in his letters to his shareholders. And Mr. Soros’ has developed the Reflexivity Theory of investing, one of the most elegant descriptions I have ever read of a YANG/YIN cycle as applied to the financial markets. What I love about his Reflexivity Theory is that it has an almost mystically religious tone and it is one of the philosophical concepts that encouraged me the most to publish my studies. I hope he will forgive me if I have misread his theory.
YANG is Heaven, a world of thoughts, ideas and financial strategies. YIN is Earth, the actual market where the real events are taking place. The investor is in YANG (his strategic plan) while observing and trying to understand what is going on in YIN (the market); however, to go through the process of understanding the market, the investor must first go to YIN to get the data. The investor then invests in YIN based on what he planned in YANG. But as changes take place in the market (YIN), he must go back to revaluate his strategy (YANG).
YIN and YANG reflect on each other in a never-ending process. By the time the investor invests in YIN with his YANG plan, YIN has already changed. Thus each one has an imperfect idea or incomplete perception of what the other is doing. What is a sobering thought is that the imperfection of the YIN is affecting the imperfection of the YANG. Thus there is imperfection in YANG, caused by the changes in YIN and the investor tries to “perfect” or make the right investments in YIN with the imperfect changes he made in YANG. Like light and darkness, YANG and YIN imperfectly reflect on each other, condemned to influence but never to touch each other. A wall separates them. In the case of the TAO, the wall has the shape of an S.
Reflexivity Theory would call the imperfect view YANG and YIN have of each other, a “flaw in perception”. There are three “flaws of perception” that the investor would find disturbing. First, the so-called specialists and analysts making all kinds of commentaries and the magnifying effect television and the Internet has on these commentaries. This is called hype. Second, is the Fed’s own “flaw in perception” of the markets and how the Fed will react to these flows. And third, is the Chairman of the Fed’s deliberate attempts to add to the “flaw” in the investor’s perceptions by talking in a language designed to baffle the investors. This is called “jawboning”. Is it any wonder the investor might consider this not a “flaw in perception” but chaos?
This same process applies to the relation between the CEO and the price of its stock. The success of a CEO’s plan (YANG) increases the price of the corporation’s stock in the market (YIN). Such increase leads to arrogance or a flaw of perception deteriorating the CEO’s plan and leading to an eventual drop in the stock price. This in turn, leads the CEO to become humble, improving the CEO’s plans and leading to an eventual increase in the price of the stock. Even though the change in YANG neither immediately nor perfectly affects the YIN, in the long run one affects the other and vice versa. For the investor the relation is the same. In an act of pride or flaw of perception, the investor would continue to buy as long as the price of the stock goes up in a momentum play even after the PE has become meaningless and in an act of panic he will continue to sell in a downward momentum play even if the corporation’s intrinsic value proves him wrong.
Both the I CHING and Mr. Soros’ Reflexivity Theory would contend there could never be a perfect equilibrium in the markets, industries, corporations, CEOs’ mental states, or in anything else for that matter. Everything is in a continuous des-equilibrium and all of us are in a constant effort to push toward equilibrium. Reflexivity Theory would argue that too much YANG automatically arouses the YIN and too much YIN automatically arouses the YANG, or too much of the CEO’s or investor’s arrogance leads to a deep reflexivity as a way out for both CEOs as well as investors.
Mr. Soros’ Reflexivity Theory would assert that even though YANG eventually leads to YIN, before that happens, however, YANG would beget more YANG without any real fundamentals to support it all the way up to its climax. And once the climax with its turning point comes and the YIN cycle starts, YIN also begets more YIN without any real fundamentals to support it all the way down to a capitulation as the situation worsens much beyond the point of reality. Again, television and the Internet both play a substantial role in affecting the investors’ perceptions on the YANG side as well as on the YIN side.
In the picture below, much like a clock, CEOs and investors will find the two great YANG symbols, Heaven and Lake, going down from 12 to 3, and the two lower YIN symbols, Fire and Thunder, going down from 3 to 6. The CEOs and investors will also find the two greater YIN symbols, Earth and Mountain, going up from 6 to 9, and the two lower YANG symbols, Water and Wind, going up from 9 to 12.
We can also picture Reflexivity Theory as a clock:
1) The great YANG – Heaven at 12 and moving downwards clockwise representing the unrecognized trend. This is the purest form of truth, the real perception.
2) The great YANG – Lake, which represents a successful test of the bullish trend.
3) The lesser YIN – Fire, which represents a growing conviction resulting in a widening divergence between reality and bullish expectations.
4) The lesser YIN – Thunder, which represents the bulls’ flaw in perceptions marked by a massive buy. (The lower the YANG or the higher the YIN the greater the flaw in perception.)
Now the self-reinforcing process starts but in the opposite direction and it will be marked by a massive capitulation at the end of the YIN cycle.
5) The great YIN – Earth, which represents the climax. This is negation, the root of evil.
6) The great YIN – Mountain, which represents a successful test of the bearish trend.
7) The lesser YANG – Water, which represents a growing conviction resulting in a widening divergence between reality and bearish expectations.
8) The lesser YANG – Wind, which represents the bears’ flaw in perceptions and which is marked by a massive capitulation. (Nothing like a good kick in the ass to keep the investor in touch with reality)
The I CHING says; “Sometimes an incorrigible fool must be punished. He who will not heed will be made to feel. This punishment is quite different from a preliminary shaking up. But the penalty should not be imposed in anger; it must be restricted to an objective guarding against unjustified excesses. Punishment is never an end in itself but serves merely to restore order.”
Mr. Soros’ Reflexivity Theory would suggest that the great YANG part of the cycle might be real. But once we reach the lesser YANG, it is no longer the fundamentals pushing the YANG but it is only the YANG itself pushing the YANG. It is the price pushing the price. It is the success that begets success without any real effort or merits. The danger lies in that as investors and as CEO’s we are heading into arrogance or what Mr. Soros would say is the catalyst for a reversal of the future – the flaw of perception. When the CEO of a corporation thinks he no longer has to be efficient, that the value of his corporation will increase only because his fame brought him to the cover of Fortune magazine; or when the investor believes the same as the CEO, then it is time for the investor to head for the door.
Every investor can sense the danger – PEs over 40, corporations selling for over 10 times their revenues, a bullish VIX, a MACD that tells us to sell, a 200 day moving average pointing downwards, most of the strategists recommending investors should place a high percentage of their asset allocation in equities, etc. And the signal of signals – a Fed acting on its own “flawed perception” out to turn an “irrationally exuberant” market into an “irrationally depressed” market by aggressively increasing the interest rates. Yet, in spite of all the signs, few investors are willing to jump out. Part of the problem lies in the fact investors tend to live in the day-to-day and forget that cycles are measured in months or years. We know by the astronomical PEs we are at the end of the lesser YANG but because we live in the day to day, we refuse to accept the climax is coming shortly.
Confucius spoke about sensing danger. He wrote in the I CHING:
“To know the seeds, that is divine indeed. In his association with those above him, the superior man does not flatter. In his association with those beneath him, he is not arrogant. For he knows the seeds. The seeds are the first imperceptible beginning of movement, the first trace of good fortune (or misfortune) that shows itself. The superior man perceives the seeds and immediately takes action. He does not wait even a whole day. In the Book of Changes it is said: “Firm as a rock. Not a whole day. Perseverance brings good fortune.”
Firm as a rock, what need of a whole day? The judgment can be known. The superior man knows what is hidden and what is evident. He knows weakness, he knows strength as well. Hence the myriad’s look up to him. “
Mr. Soros, Mr. Buffett and Sir John Templeton are some of the true heroes of mankind; definitely they are some of mine. Mr. Soros took it upon himself to take an active part in ridding the world of communism, to beat the Random Walk Theory, and to make a fortune for himself and for his investors. And he accomplished all of this with great humility. But to me Mr. Soros as well as Mr. Buffett and Sir John Templeton are Superior Men in the sense the I CHING wants us to be Superior Men.
Superior Men do many things, but in the world of investing they must do one thing above all else. They must fight evil and its nature: an attitude based on negation. Speaking of the nature of evil, the I CHING says:
“Evil is not destructive to the good alone but inevitably destroys itself as well. For evil, which lives solely by negation, cannot continue to exist on its own strength alone. The inferior man himself fares best when held under control by a superior man.”
Mr. Soros’ move on the British Pound was a classic example of moving in against negation or the “flaw of perception”. Mr. Buffett’s purchase of American Express during one of its darkest periods and the reduction of positions in Coca Cola, after the death of Mr. Goizueta, and in Disney were classic examples of making the most of investors’ negation. And Sir John Templeton’s aggressive buying of Japanese stocks when no one thought much of Japan was also a classic example of making a fortune out of someone else’s negation.
One of the lessons the I CHING teaches us is that it is not only important to know the fundamentals about a corporation. A good CEO and a good investor must also know about the laws of the Universe. For the CEO and the investor, knowing about the I CHING and the basic forces of YANG and YIN might be of help.
